A convertible loan is a loan that´s meant to convert into equity (normally including any accrued interest) instead of being paid back.
→ Normally used in the very #early stages of a #start-up (eg. prior to the first larger equity financing round or as a bridge financing prior to a further financing round).
When is the loan convertible?
The conversion is made dependent on the occurrence of a certain event, the so-called conversion event. Depending on the specific terms and conditions of the convertible loan, conversion events can trigger either a conversion right and/or a conversion obligation.
Conversion events can either relate to an actual event, usually a (qualified) equity financing round or an exit, or to specific point in time, usually the conversion at the time of the expiration of the fixed term.
While convertible notes have an agreed maturity date, when the loan is technically due, most investors will agree to extend the date if a qualified financing has not yet occurred.
An automatic conversion clause ensures the debt will convert into equity in the next qualified financing.
What will be the price per share on a conversion?
The amount of equity the loan converts into is based on the valuation calculated at the next funding round.
- It will normally convert either at an agreed price;
- or (more commonly) at a discount against the price achieved per share in the qualifying round of funding. A discount gives the VC a price reduction on the debt´s eventual conversion to equity.
The investor may also insist on a valuation cap (max-min), protect the investor in the event of a sudden increase in the investee company’s valuation. The loan would still convert to equity at the trigger event (i.e. the qualifying round or the specific date) but at a different price based on the valuation cap. The higher the valuation cap, the better for the founder.
A convertible loan may bear interests (generally 3–8% p.a. in German Market), which rather than being paid regularly, are usually added to a principal. The investee company may look to negotiate a position whereby the loan only accrues interest if it is redeemed, rather than converted into equity. Furthermore, the investee company may seek to defer interest payments under the convertible loan. This would have natural benefits for the company’s cash flow.
Advantages for Founders
- Founders can negotiate with a large number of investors in parallel and generally independent of each other and raise funds with little effort sequentially. Negotiating separately often means that a founder will get better terms for the final round.
- During the term of the convertible loan, the existing shareholders are not diluted, the (legal) cap table remains “clean”.
- Compared with the consummation of an equity financing significantly lower transaction costs and faster (short-term) implementation.
- The difficult process of company valuation can be deferred to the next financing round.
- Convertible loans allow for the establishment of a manageable and less complex governance structure (for example with respect to information obligations, consent rights, etc.).
Disadvantages for Founders
- Getting a lot of convertibles can be a dangerous game — more investors on board means your cap table can get crowded quickly and negotiations time-intensive and messy.
- In case of a lower than expected valuation on the next rounds, this could mean that you have to give away more shares than you plan to.
- In case the company cannot request the conversion of the convertible loan, this might negatively impact future financing rounds (inherited liability).
- If and to the extent no conversion occurs, the loan amounts (including interest accrued) need to be repaid, which results in a loss of liquidity.
- If a conversion occurs as part of a (future) financing round, additional shares are issued and existing shareholders are (additionally) diluted, even though no additional new capital is raised.
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Greulich, S., & Kaniak, C. (2019). Convertible Loans for Tech Companies. Orrick Legal Ninja Series — VC & TECH Briefing Germany, 1–81.